OTC Markets

As discussed in Part 1 – Market Structure, the U.S. OTC market contains the same participants and incentives as other U.S. markets. The same is true for trading in OTC securities.

OTC trading, and all securities trading, responds to the supply and demand in the market place for certain securities. Individual investors, professional investors, and broker-dealers desire to buy and sell securities at certain prices. The number of orders, the volume (e.g., share size), the timing of buy and sell orders, and the availability of information determines how prices will move for a particular security.

The best way to illustrate the OTC market trading process is to step through a specific example. This example is tailored for individual investors, although many of the same principles apply to institutional investors.

1. Investor Selects a Broker-Dealer – Only FINRA registered broker-dealers may execute trades, so investors must select a broker-dealer (or multiple broker-dealers) to execute trades.
2. Investor Makes an Investment Decision – The most difficult decision is the investment decision which should be based on thorough research on the company and security. OTCMarkets.com provides investors with comprehensive, in-depth data, including trade data, company news, and company financials to help facilitate an investor’s investment decisions.
3. Investor Defines the Order – Investors must define the order they wish the broker-dealer to execute. There are two main order types: the Limit Order and the Market Order.
   • Limit Orders allow investors to specify the exact price they are willing to accept for a buy or sell order. While Limit Orders are designed to offer more price protection for investors, a Limit Order may not be executed if the price of the security does not reach the price stated in the Limit Order.
   • Market Orders direct the broker-dealer to immediately execute either a buy or sell order at the current ‘market price’ – the best bid or offer.
   Investors must decide whether price (Limit Order) or timing/immediacy (Market Order) is more important to them.
4. Broker-Dealer Executes the Order – Once a broker-dealer receives an order, they often go through the following steps/decisions as part of the trading process:
   1. Execute Trade Internally
   2. Trade Marketable Order Externally
   3. Create/Edit Quote on Inter-dealer Quotation System
   4. Trade Non-Marketable Order Externally
   1. Execute Internally – Broker-dealers usually will first determine if they can or choose to execute the trade internally. Internal executions occur if they can ‘match’ (same prices for a buy and sell order) Limit Orders or if they choose to trade for their own account. If they are trading for their own account, they must give investors their limit order price or the NBBO (National Best Bid or Offer) as defined by an Inter-dealer Quotation Systems (OTC Link/FINRA BB) at that point in time. This rule is known as ‘Best Execution’ and is among the regulations discussed in Part 3 – Regulation.
   2. Trade Marketable Order Externally – If the broker-dealer cannot, or chooses not to, execute the trade internally, they must attempt to execute the trade with another broker-dealer. This often means accessing the security on OTC Markets Group’s OTC Dealer application and ascertaining whether the order is marketable. Marketable orders are orders where the price specified can immediately be executed in the market. Market Orders are, by definition, marketable. Limit Orders are marketable if the limit price is better than or equal to the bid price (for sell orders) or ask price (for buy orders). For example, a customer’s Limit Order to buy security XYZ for $30 will only be marketable if the offer/ask price is $30 or less. If the offer price is $30.01 then the limit order is not marketable and will not be executed. If the order is marketable, the broker-dealer may utilize OTC Link to negotiate a trade with a specific broker-dealer (or group of broker-dealers) or contact the broker-dealers by other means of communication.
   3. Create/Edit Quote – If the order is not marketable, the broker-dealer may create or edit its existing quote on an Inter-dealer Quotation System (e.g. OTC Link) to reflect a new price or size. The quote lets all other broker-dealers know the price which they are willing to buy or sell. Broker-dealers are only required to update their quote if the price of the order is equal or superior to their existing quote (See FINRA Rule 6460 in Part 3 Regulation). In many cases, a broker-dealer quote is the aggregation of a number of customer orders. Often, at a customer’s request, Broker-dealers will not display the entire order to other broker-dealers because this information may cause the other broker-dealers to move their prices resulting in inferior or no execution.
   4. Trade Non-Marketable Order Externally – Once broker-dealers have created or updated their quote, they may continue to monitor the market; if prices change (to satisfy the limit price) they may send a trade message to another broker-dealer. They may also receive an OTC Link trade message against their standing quote or for a different price/size. For example, another broker-dealer may have a marketable order. At that point the broker-dealer may accept, decline or counter (send a different price or size) the offer to trade. This is one of the main differences between OTC trading and listed security trading. There is no central system that matches/executes orders in the OTC – all trades are agreed upon directly between the broker-dealers. OTC Markets Group’s OTC Link system facilitates the speed at which trades are negotiated. Broker-dealers are liable for their quote price and size, and those firms that decline liable orders are subject to penalties from FINRA.

      Firms may also negotiate trades over the phone. While the same process and rules apply, the speed with which trades are executed is inherently slower than OTC Link.

5. Broker-Dealer Reports, Clears and Settles Trade – Once broker-dealers accept an offer to trade through OTC Link or through another means of communication, they must report, clear, and settle the trade. Part of this process is the confirmation of the trade with the investor; however, the trade will not be complete until final settlement (the delivery of funds by the buyer and securities by the seller), which, for equity securities is generally three business days after the trade date (T+3). While OTC Markets Group’s products and services facilitate the reporting, clearing, and settlement process by transmitting trade data to the broker-dealers, all three functions are the responsibility of the executing broker-dealers.
   • Reporting – Broker-dealers are required to report their trades to FINRA within 30 seconds of the execution. This information is then disseminated by FINRA to the market. OTC Markets Group offers this ‘real-time’ trade data within a number of its products (OTC Dealer, OTC Quote.com, OTCIQ – Market Intelligence). All other trade information is on a 15 minute delayed basis.
   • Clearing and Settlement – For OTC equity transactions, clearing and settling, the matching of trades and the movement of money and securities, is often handled by third-party firms for the broker-dealers.

This trading process example is very basic but it helps to explain how the OTC market efficiently trades in excess of $600 million on a daily basis.

Let’s now see how regulation affects OTC market structure and processes in Part 3 – Regulation.